Download Economics Scholarship Exam 2008 These are my Economics Schol

Economics Scholarship Exam 2008
These are my Economics Scholarship Exam answers for the 2008 exam. My final mark was 43/48,
the required pass mark was 28/48 and 38/48 for Oustanding. There were 6 questions, all worth 8
marks each for a total of 48 marks. Note that (although I would really like to!) I have not edited any
of my answers at all so that you can get a fair idea of what is required.
My marks are as follows (this is what the assessors flap looked like):
Question Number
Marks
(a) and (b)
8
(8)
One
(c)
8
(8)
(a) and (b)
6
(8)
Two
(c)
6
(8)
(a) and (b)
7
(8)
Three
(c)
8
(8)
TOTAL
43
(48)
To download the resource booklet, go to:
http://www.nzqa.govt.nz/scholarship/subjects/resources.html
Question 1
(a) A lack of elasticity has contributed to the rise in the price of petrol in 2008 (8 out of 8
marks).
(i) Referring to Resource A:
1) Calculate the price elasticity of demand for petrol (to 2 decimal places and show your
working) .
PED = (93.4m-95.7m)/((95.7m+93.4m)/2)/((1.89-1.52)/((1.89+1.52)/2)) = 0.0243/0.217 = -0.11
2) Calculate the cross elasticity for rail transport against petrol prices (to 2 decimal places and
show your working).
CED= %ΔQ/% ΔP = 14.32/((1.89-1.52)x100/1.52) = 14.2/24.34 = 0.58
3) Briefly comment on what your coefficient in (2) above identifies
This shows that petrol (I.e. car usage) is a substitute for rail transport
(ii) Briefly suggest why petrol is considered to be price inelastic with respect to both demand
and supply in the short run, and then explain why this combination leads to large,
sudden changes in prices.
1) Demand:
Petrol is considered a necessity. There are not many close substitutes (i.e. some cars must run on
petrol) and petrol is not easily postponable. The degree of responsiveness of quantity demanded to
a change in price is therefore low, i.e. inelastic.
2) Supply:
In the short run at least one factor input is fixed i.e. it takes a large amount of time to dig for more
oil/set up new fuel stations. This leads to a small degree of responsiveness of quantity supplied to a
change in price, hence inelastic supply.
3) Why this combination leads to large, sudden changes in prices:
As both demand and supply of petrol are relatively inelastic, a change in demand or supply will lead
to a shortage or a surplus. Due to the inability to respond well to changes in price, a large bidding up
of price must occur to clear the shortage, or a large drop in price would be needed to clear
surpluses. Hence large changes in price occur when factors affecting demand or supply change.
(iii) Using Resources B and C and your answers to the earlier parts of this question, draw a
supply and demand diagram to show the price of crude oil increasing from US$60 in
2007 to US$135 in 2008.
World Market for Crude Oil
Price ($US)
S
135
60
D1
D
Q
Q’
Quantity
(b) Using Resources C and D and your own knowledge, explain how and why the price
elasticities of demand and supply for transport fuels will change over time.
(i) Demand:
In the long run, price elasticity of demand will be relatively more elastic (higher). This is because over
time, other transport fuels are developed and consumers can switch to cars that run on other fuels
(whereas in the short run they can’t). This leads to there being closer substitutes in the transport
fuels market, allowing consumers to respond more to changes in price by switching to other cars,
which require cheaper transport fuels. This increases responsiveness of quantity demanded to
changes in price and increases elasticities.
(ii) Supply:
In the short run, elasticity of supply is limited worldwide due to “insufficient transport and refining
capacity” and due to “political and ethnic conflicts”. This means in the short run, firms suffer from
having fixed inputs such as refining buildings, roading etc. Therefore elasticity in the short run is
inelastic. In the long run, firms are able to add to transport and refining capacity by building new
roads/trucks and buildings. This is due to all factors being variable in the long run. This increased
capacity for oil producers enables petrol and other transport fuel producers to receive larger
quantities of oil in the long run. They can therefore respond easier to changes in price, increasing the
elasticity of supply in the long run.
(c)Evaluate the extent to which price elasticities will influence the effectiveness of taxes and
subsidies that are used to discourage the use of fossil fuels and encourage the use of more
efficient passenger transport. You should refer to Resources D, E, and F as well as your analysis in
the previous questions. Use appropriate diagrams/models in your answer. (8 Out of 8 marks)
Elasticity of supply and demand has a huge impact on the effectiveness of taxes in shifting from less
efficient to more efficient transport use. In the short run, both supply and demand are very inelastic
for fossil fuel related transport. This leads to a problem for the Government who aims to reduce
emissions. This is shown below:
Market for Fossil Fuel Related Transport (Short Run)
S+tax
Price per Litre ($)
S
Pc
Tax per Litre
P
Pp
D
Q1 Q
2
Quantity (Litres)
A large per litre tax on these fuels such as petrol, in the short run, only leads to a very small
reduction in the actually quantity consumed (moves from Q to Q1). The increased price does not
deter consumption in the short run and the tax is ineffective. However, the Government collects a
large amount of revenue (shaded area) from this tax due to its large per unit tax and small reduction
in quantity. This revenue could be used to subsidise other, less emissive/more efficient methods.
The Government could also use this revenue to improve the efficiency of these alternate transport
methods by investing in bigger electric rail networks.
In the short run, a subsidy to encourage more efficient transport, such as electric trains, is unlikely to
have the desired effect. The decrease in price received by consumers is unlikely to result in large
increases in travel by consumers as the electric train networks are not available everywhere and
hence consumers cannot switch away from private transport such as petrol cars etc. as they regard
these as necessities. This is shown below:
Market for Electric Rail Travel
S
Price per Trip ($)
S+subsidy
Pp
Per trip subsidy
P
Pc
Q
Q1
Quantity (Trips)
The elasticity of supply and demand here is also inelastic. The private firms/government cannot
quickly implement new routes in the short run, so supply is relatively inelastic. Demand is also
inelastic, a significant decrease in price will bring about a proportionately smaller increase in
quantity demanded. This is because networks are not set up everywhere, those who are on existing
routes may have elastic demand, but throughout the entire economy relatively few consumers will
benefit from the decreased price. Hence there is only a small quantity consumed increase (Q to Q1)
when the subsidy is implemented. The subsidies in the short run are likely to result in only a small
reduction in emissions, hence in the short run are an inefficient use of Government spending. The
shaded area shows the substantial amount of subsidy required to increase consumption by only a
small level.
In the long run, all factor inputs are variable. Supply and demand elasticity is higher as they can
respond to changes in price. This leads to the Government’s use of subsidies to encourage efficient
transport being very effective and taxes on petrol and diesel being very effective at reducing
consumption.
Long Run Market for Fossil Fuel Related Transport
Price ($)
per Litre
Long Run Market for Electric Train Transport
Price ($)
S
S+tax
S+subsidy
S
Tax oer litre
Pc
Per trip subsidy
Pp
P
P
Pp
Pc
D
D
Q1
Q
Quantity (Litres)
Q
Q1
Quantity (Trips)
Above, shows that due to the increasing elasticities over time, taxes to reduce consumption of fossil
fuel transport and subsidies to encourage consumption of electric train (or other efficient transport
systems) are effective in having their desired effects. However, these policies create some issues in
the economy. Taxes on private transport effectively work as regressive taxes, reducing equity in the
economy, as lower income earners lose a greater proportion of their income as tax. Subsidies have
the opposite effect, of increasing equity, as low income earners benefit from greater purchasing
power more than higher income earners. Provided both policies are implemented in the short run,
equity is not affected. In the long run, equity should be improved and consumers can switch to
cheaper (more efficient) electric trains. This results in lower income earners bearing a greater
proportion of benefits than high income earners.
Another issue is the Deadweight loss associated with Government intervention. This occurs as
resources are allocated away from their more efficient use in the production of fossil fuel transport
towards less efficient use in electric train transport (shaded ).
Overall, if the Government taxes fossil fuel consumption in the short (and long) run they can gain
large amounts of revenue. This revenue can be used to help existing electric train networks improve
their efficiency and to subsidise their use. The effectiveness in reducing consumption in the short
run is limited, but in the long run the desired reduction in emissions occurs (due to increasing
elasticities).
Question 2
(a) A natural monopoly can be a justification for government intervention (6 out of 8 marks)
(i) Define a natural monopoly and explain the ways in which the railways in New
Zealand would qualify as a natural monopoly.
A natural monopoly is a monopoly (only firm in the market) which can supply the entire markets at a
lower cost and price than two or more competing firms. It has a downward sloping AC curve over
the relevant output range. This is due to existing economies of scale, high setup costs and/or control
over an essential resource. NZ Railways qualifies as they own the railways themselves are the only
firm, benefit from existing economies of scale and thus fulfil the criteria of natural monopolies.
(This part of the question was marked as a cross i.e. incorrect. After looking at the marking
schedule and reading my answer I am still sceptical as to why this was not sufficient)
(ii) Draw a graph to illustrate a natural monopoly operating at the profit-maximising level of
output.
Natural Monopoly Firm
Costs/Revenues
($)
Ppm
AC
MC
AC
Ps
Qpm MR
Qs
AR
Quantity
(iii) With reference to your graph above, explain the impact of this level of output on
allocative efficiency.
The natural monopoly overprices (Ppm rather than Ps) and under-produces (Qpm instead of Qs).
Therefore the natural monopoly is not allocatively efficient. A Deadweight loss results ( ) from this
level of output and the firm makes super-normal profits ( ). The natural monopoly results in a loss
of efficiency by not operating at the socially desirable equilibrium (Ps/Qs).
(iv) Why might an economist disagree with the writer’s comment in Resource G: “Whether is it
Auckland International Airport, The Warehouse or Vector, the issue is the same.”?
An economist may believe that Auckland international airport is more efficient than two or more
competing airports. They may believe that by avoiding unnecessary duplication of resources,
Auckland International Airport is a true natural monopoly and thus the existence of it is not the
same as The Warehouse or Vector. Auckland Internation Airport may use super-normal profits for
investment purposes, increasing efficiency. The economist might argue that The Warehouse and
Vector could be deregulated but the International Airport is a true natural monopoly and its
existence is justified.
(This part of the question was marked as a cross i.e. incorrect. The reason for this is I did not say
The Warehouse is an oligopoly and Vector a natural monopoly. I guess this is because I had no idea
what Vector was)
Road transport has externalities
(b) (i) It is stated in Resource H that “road transport in itself does not carry its full costs”.
Explain this statement with the help of an appropriate diagram.
NZ Market for Road Transport
Costs/Benefits
MC=SMC
Ps
PFM
Per unit negative spill-over
MB
SMB
Qs
QFM
Quantity
This statement means the free-market fails to take into account the negative spill-overs (externality)
resulting from consumption of private transport. As a result, the marginal social benefit (SMB) is less
than private marginal benefit (MB) and cars are over-consumed/under-priced.
(ii) On your diagram above, identify the loss of allocative efficiency of road transport.
= loss of allocative efficiency
(iii) With reference to your answers in (b) (i) and (ii) on the previous page, would government
measures to encourage rail instead of road transport be justifiable? Explain.
At the free market equilibrium (QFM and PFM) the road transport is over-consumed and underpriced in comparison to the socially desirable equilibrium (Qs and Ps). The market is allocatively
inefficient. If the Government were to subsidise rail transport, this would lead to a fall in its price
(substitute for road transport). This would lead to increased quantity demanded for rail transport
and a decrease in demand for private transport. Thus the market would move towards the socially
desirable/allocatively efficient equilibrium quantity. This is a good idea as it increases efficiency and
reduces private transport (reduces Deadweight Loss). This Government action is justified.
KiwiSaver effectively decreases the disposable income of households as a portion of their wages are
put into their KiwiSaver account. With a decrease in disposable income, households would demand
less goods and services causing aggregate demand to shift to the left. Therefore if tax cuts are
implemented, the government would have to make sure they are not too extensive as they would
want to reduce the possibility of aggregate demand rising because of inflationary pressures.
However tax cuts are possible because the decrease in aggregate demand caused by KiwiSaver
would be helpful in reducing the likelihood of aggregate demand increasing.
(c) Evaluate the Government’s decision to nationalise the railways in New Zealand, instead of
intervening in other ways, in order to achieve a more socially desirable outcome from this
natural monopoly. You should refer to Resources G, H and I as well as your analysis in the
earlier parts of this question. Use appropriate diagrams/models in your answer. (6 out of
8 marks, both marks were lost for lack or reference to the Resource material. Learn a
lesson from my mistake!)
The Government had a few options with regards to natural monopolies and forcing a more
allocatively efficient outcome. Nationalisation results in the Government purchasing the railways
and running them as a state-owned-enterprise. This results in them being able to set the price equal
to the socially desirable price and result in a removal of the Deadweight Loss. As they would be
making sub-normal profits, this would be funded through taxes. The Government is also likely to
provide ‘strong investment’ and return railways to an efficient and well up-kept service.
The benefits of nationalisation are that it achieves a socially desirable outcome (Ps/Qs) and may
improve equity, as a lower price enables low income earners to afford a good/service they
previously could not afford. The large negative impact the Government operation is likely to cause is
that it is likely to be less efficient than private ownership, hence the industry (rail) is less efficient
under public ownership. Therefore the Government must have believed it is now more efficient than
when they privatised the New Zealand Railways in the 1980’s.
The Government could have forced the natural monopoly to produce where average cost equals
average revenue. This is known as average cost pricing and results in the firm earning normal profits
as shown below.
New Zealand Rail Natural Monopoly
Costs/Revenues
($)
Ppm
MC
AC
PAC
Ps
QPM QAC Qs
Quantity
AR
MR
At this level of output (QAC) and price (PAC) there still exists a deadweight loss (DWL), as it is still not
allocatively efficient. However, the DWL is significantly reduced in comparison to the profit
maximising output and hence efficiency is improved. The positives of this is that it is still privately
owned, so may be more efficient than nationalised railways. Also, a more efficient (closer to socially
desirable) quantity and price is provided, improving efficiency. It also does not require a subsidy. The
negatives are that it is still not allocatively efficient, a deadweight loss exists. Also, it may encourage
the firm to inflate their costs when they submit them, resulting in inefficiencies. This is because
average cost includes opportunity costs and it is difficult to establish a fair rate of return.
Another possible policy is forcing (regulating) the railway firm to operate where price equals
marginal cost. This is known as marginal cost pricing and occurs where supply equals demand, at the
socially desirable equilibrium. This is good for the economy as it is allocatively efficient, no
deadweight loss occurs and supply equals demand. It may be seen to improve equity, by reducing
price so that lower income earners an enjoy the benefits of a good/service they previously could not
afford. It is also still privately owned so is likely to be more efficient than under public ownership
(through nationalisation). Marginal cost pricing is demonstrated below.
New Zealand Rail Natural Monopoly
Costs/Revenues
($)
Ppm
MC
AC
AC
PMC = AR
QPM
MR
QMC
Quantity
The major negative of marginal cost pricing is that it earns the railways a subnormal profit. No
producer will continue in the long run when average costs exceed average revenue. Hence a subsidy
(of the shaded area equal to the area of subnormal profits) would be required to keep NZ railways in
business at the marginal cost (MC) pricing level. Although MC pricing can be seen to increase equity,
it could also be said to decrease it. Those who do not use the railways will still be contributing to it
(through their taxes being turned into subsidies for NZ railways), may think of it as unfair that they
contribute towards a good/service they do not consume.
The Government could have also attempted to remove artificial barriers to entry to promote
competition, but this would be extremely difficult, leading to unnecessary duplication of resources.
Overall, the Government had three main choices, each of which had positive and negative aspects.
In my opinion, provided the Government operates the railways efficiently, they can reduce costs for
firms and prices for consumers, encouraging growth (increasing aggregate supply due to falling costs
of transport); the nationalisation idea is possibly the most efficient. Average cost pricing does not
completely remove the deadweight loss and thus is not socially desirable. Marginal cost pricing is
allocatively efficient but requires a subsidy due to the subnormal profits created by the Government
regulation (to where P=MC).
Therefore, assuming the Government runs the railways efficiently, improved equity and improved
efficiency result. The economy benefits from growth and overall their policy is effective at creating a
socially desirable price and quantity. All three policies are likely to slightly increase employment also,
as demand for labour increases to handle the increased output.
Question 3
(a) The economy is experiencing “the perfect storm” (7 out of 8 marks)
(i)Draw an aggregate demand and aggregate supply diagram to show the New Zealand
economy operating at the full employment level of national income.
New Zealand Aggregate Economic Activity
AS1
Price level
Recessionary gap shown as
gap between Y1 and Yf
PL
PL1
AD1
Y1
(ii)
(1)
(2)
(3)
AS
Yf
Y
AD
Real GDP
On your diagram above, identify:
The impact of the credit crunch affecting world financial markets in 2008
The impact of the increase in the world price of crude oil
The recessionary gap
(iii) Explain the changes to aggregate demand and aggregate supply, AND the impact
of those changes on the New Zealand macro-economy
The credit crunch affecting world financial markets has lead to a reduction in worldwide
consumption. This leads to a fall in demand for our exports (overseas incomes fall/consumer
confidence overseas falls). This reduces our export receipts. Loss of sales results in a fall in business
confidence and thus a reduction in investment spending. These effects combine to reduce aggregate
demand. Increase in price of crude oil flows on to increased fuel prices and thus increasing costs of
production for firms in New Zealand. Firms plan to produce less at each price, resulting in a
reduction in aggregate supply. Overall these impacts result in a large decrease in output and
employment in New Zealand. Also, the effect on the price level (in my model) is a slight
disinflationary effect in the NZ economy, but this will depend on the relative sizes of the curve shifts/
There has been much discussion this year about recession.
(b) (i) Define a recession and draw a business cycle illustrating a recession.
A recession is defined as being two consecutive quarters of negative Real GDP Growth.
New Zealand Business Cycle
Growth in Real
GDP
Potential
Growth
Actual
Growth
Time
Negative
3
5
(ii) Discuss the extent to which a recession in the United States will have a detrimental impact
on the performance of the New Zealand economy.
A recession in the United States will lead to falling output, falling demand for labour and hence
falling incomes in the United States economy. These consumers in USA who have decreased incomes
will demand less of our exports, hence our export receipts (X) will fall. This will result in a reduction
of injections into the circular flow and (ceteris paribus) a reduction in money flows in the New
Zealand economy. This leads to a reduction in growth in New Zealand. Effect on aggregate activity
can be considered using AS/AD analysis. A reduction in export receipts leads to a worsening of the
current account balance. Also, low business confidence results in less investment spending (I). Lower
output levels (from less exports) results in less demand for labour as firms can no longer afford to
hire as many workers. This leads to rising unemployment and falling incomes. Falling incomes results
in a reduction in consumer spending (C). This cycle will continue and a reduction in C, I and X, all lead
to a reduction in Aggregate Demand. Output/Growth in the NZ economy is reduced and the NZ
economy may slump into a recession if the effects on Aggregate Demand continue and if the
Government does not take action. (The credit crisis has resulted in NZ spiralling into a recession).
This is detrimental to the NZ economy in terms of growth.
(This part of the question was marked as two ticks and a cross. I did not discuss the effects on
foreign investment in New Zealand i.e. the Financial Account and hence lost the mark for that)
(c) Evaluate the policy responses available to the government to minimise the impact of the
economic downturn overseas on the New Zealand economy. You should refer to the
information provided in Resources K to O and your own knowledge of macro-economic
theory. Include appropriate diagrams/models to support your answer. (8 out of 8 marks)
The New Zealand Government has a number of possible policy responses that could be used to
prevent, or minimise the effects of, a downturn in the New Zealand economy. The Government itself
implements fiscal policy, which is the use of government spending and taxation to influence growth.
The government can also work alongside the Reserve Bank by suggesting to the Reserve Bank
Governor to change monetary policy. Although the Reserve Bank operates independently of the
Government, the Government can still suggest what they believe must happen to monetary policy.
The Government’s first option could be to cut income tax rates. This would lead to an increase in
disposable incomes in the economy (expansionary fiscal policy). This would lead to an increase in
consumer spending, which would lead to a rise in business confidence. Business confidence is a
major determining factor for investment. Investment levels are likely to rise. These effects lead to a
net increase in Aggregate Demand as shown below:
New Zealand Aggregate Economic Activity
AS
Price level
PL1
PL
AD1
AD
Y1
Y
Yf
Real GDP
This leads to an increase in output and employment from Y to Y1. However, this causes inflationary
pressures (From PL to PL1). This will add to already high inflation due to decreased aggregate supply
resulting from “increases in business raw materials prices”. Overall, this cut in income tax (PAYE) has
lead to rising inflationary pressures (which may impact on our price competitiveness if sustained in
the long term) but a rise in output, incomes and employment. If this provides the necessary
incentives for adequate spending and investment, it may help reduce the recessionary spiral and
minimise the effects of the global economic downturn. This may lead to a reduction in equity. A
reduction in PAYE/Income tax increases incomes of higher income earners greater than that of lower
income earners. This reduces vertical equity in the economy.
The Government could also reduce company tax (as a separate possibility or together, as part of
expansionary fiscal policy). This will increase profitability for firms and result in increased investment
from both new and existing firms. This will increase their level of potential output and could flow on
into increased demand for labour to work the new machinery:
Market for Skilled Labour in NZ
SL
Real Wage
(W/P)
Shortage
W1
W
DL
Q
Q1
Qf
DL1
Quantity of Workers
Increased demand for labour results in a shortage of labour at W. Firms offer wage increases to
attract workers. Quantity of labour supplied increases and quantity of labour demanded decreases,
until the shortage is removed and new equilibrium reached (at W1, Y1). Rising wages leads to
increased consumer spending and this combines with the increased investment spending to increase
aggregate demand (see diagram on previous page, effect is the same). This would have a similar
effect on growth (increasing growth/minimising the recessionary effects) and increasing the price
level.
The Government could also increase its spending on roading and transport systems (such as
improving rail networks). This is also expansionary fiscal policy and works as a supply-side as well as
a demand-side policy. By increasing spending, the Government directly increased aggregate demand
(G component). Also, the improved efficiency of transport systems results in a decrease in transport
costs for firms. This decreases costs of production and (as firms plan to produce more at each price
level) increases aggregate supply. This is illustrated below:
New Zealand Aggregate Economic Activity
AS
Price level
AS1
PL
PL1
AD
Y
Y1
AD1
Yf
Real GDP
Overall, this increased Government spending on transport systems has the potential to benefit the
economy the most. Through a reduction in inflationary pressures (such as those caused by increased
business costs (Resource M)) and an increase in Real Output/reduction in unemployment, this policy
has the most favourable impact. Unfortunately, this response is more of a long term policy, as its
initial effects would only be the small increase in Aggregate Demand and thus is not effective at
minimising the effects of the global downturn.
If the Government is successful in convincing the Reserve Bank Governor to change monetary policy,
the effect is a loosening of monetary policy i.e. a reduction in the Official Cash Rate. This decreases
retail interest rates. Savings are less attractive, mortgage repayments fall (increasing discretionary
incomes), NZ exports become relatively cheaper, export receipts increase and import payments
decrease due to increasing relative price from a depreciation of the $NZ (Shown on next page):
Foreign Exchange Market for $NZ
S$NZ
Exchange Rate
($US)
S$NZ1
E
E1
D$NZ1
Q
Q1
D$NZ
Quantity
The net effect of this is a large increase in Aggregate Demand (refer to page 15 for graph). This is
favourable. However, the depreciation may cause aggregate supply to fall (increased costs for raw
materials) and even greater inflation rates, with only a small increase in output.
Overall, the best policy is probably an expansionary fiscal policy with a combination of a reduction in
company tax and income taxes to stimulate economic activity. This would be successful in
minimising the impact on the NZ economy of the global downturn in economic activity with only a
small increase in inflationary pressures (due to low position on Aggregate Supply curve i.e. not near
full employment level of resources, so low competition for scarce resources).